The management of Madesco Incorporation is exposed to the risks of exchange rates and if in future the exchange rate of the company which is the USD depreciates in value relative to the Deutsche Mark then it is going to cost a lot for the company. Since the company is selling its old inventory at discounted prices, therefore, the company would be sacrificing the profit margins and if now the exchange rate fluctuations turn out to be against the company then the company would be incurring huge losses as the amount of the transaction is about 30 million DM.
A range of options are being considered by the treasury group of the company. The two options that have been evaluated here which are the forward contracts and the options contracts.
Forwards
The first hedging strategy that has been used in order to evaluate the future position of the company is the forward contracts. It is currently March 1, and the delivery would be made on September 1 which is 6 months away. Therefore, 6 months forwards would be used. The management of the company would buy the forward contract at the forward rate of 1.83 DM per USD. If this rate is expressed in USD terms then it would be 0.546 USD per DM. If we calculate the total cost at the time of the delivery at this effective rate, then it would be around $ 16.38 million for the company.
The advantages of using a forward contract would be as follows:
- Forwards could be easily matched with the size and the time period of the exposure.
- These are tailor made products and they could be written for any term and amount.
- Price protection is another benefit of forwards.
- Forward contracts are not complex and they are the most easiest to understand.
The disadvantages of using forwards are as follows:
- Default risk is embedded in this product.
- A counter party cannot be found easily.
- The capital is usually tied up in this agreement.
Options
The second option available to the management of the company is to use the options contract. Since the company will have to sell dollars in September or now to buy DMs, therefore, the put options have been used to evaluate the transaction. Put option would give the right to sell, therefore, the maximum strike price of 55 has been chosen and the premium at this strike price for the September options in USD would be 43.47. The single contract size is 62500, therefore, a total of 480 contracts would be needed and the total premium in USD would be 20866 dollars. Lastly, the effective rate in USD would be 0.547 USD per DM and the total cost is going to be $ 16.41 million.
Advantages of options are:
- Under this alternative the capital is not tied up.
- The terms of the options are standardized as they are traded on an exchange.
- Losses could be limited through options.
- As they are traded on an exchange therefore, options are regulated.
The disadvantages of options are:
- Options are less liquidity and they have higher spreads.
- Premium cost is one of the significant costs.
- Options are not available for all terms and sizes of transactions.
Recommendation
Based upon the evaluation of both the options and looking at the pros and cons of each of the hedging alternative it is recommended for the management of Madesco Incorporation that it should go ahead with the forward contracts option as under this option the management of the company will have to sell less dollars to pay the outstanding amount of 30 million DM. Therefore, the forward contract is the most suitable contract for the company.
The calculations for the forward and the options have been performed in the excel spreadsheets which are shown in the table below:
The total amount of the exposure is 30 million DM and this is a huge amount. On the other hand the company would be receiving this amount and not paying this amount to any other party. Therefore, the level of the foreign exchange risk is very much higher and it needs to be hedged right now so that the management of the company does not faces any issues with its future cash flows and it flow towards the company with less volatility. This is ultimately going to boost the profits for the company and provide a cover to the company from all sorts of foreign exchange risks...........................
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